Demystifying Certificate of Deposit (CD): A Safe Path to Steady Returns
Certificate of Deposit (CD) is a kind of savings account offered by banks. Generally, credit unions offer a similar product called Share Certificate, but some state-chartered credit unions offer CDs. CDs and share certificates are both low-risk deposit accounts that allow your money to grow at a fixed rate over a fixed period or term. They are similar in that both require you to leave your money in the account for the selected term in exchange for higher rates, and you may face penalties for early withdrawal. However, there are some key differences between the two. These include:
CDs pay out interest, while share certificates pay dividends
CDs are insured by Federal Deposit Insurance Corporation (FDIC), while share certificates are insured by National Credit Union Administration (NUA). Both CDs and share certificates are insured up to $250,000
CDs generally offer higher returns than regular savings accounts and money market, although the returns may not be as high as what is obtainable in the stock market. CDs, however, have significantly lower risks and predictable returns than the stock market because of the fixed interest rate.
The frequency of compounding of CDs depends on the financial institution. Daily and monthly compounding are more common, but CDs may be compounded quarterly or annually as well. The more frequently interest is compounded, the more interest the CD will earn. The frequency of compounding is reflected in the CD's annual percentage yield (APY), which is calculated based on the assumption that the interest will remain in the CD for its entire term.
At the maturity of a CD, you have the following options:
Withdraw your money. You can use the cash, start a new CD or invest in another financial product.
Roll-over the CD into a new one with similar terms. However, the interest rate may not be the same. So, you want to consider the interest rate before choosing this option. Roll-over option is generally selected at the beginning of a CD term but when a CD rolls over, you have a grace period to cancel the new term and withdraw the money.
One of the best strategies for maximizing returns on CDs is to develop a CD ladder. CD ladder involves investing in multiple CDs with staggered maturity dates. It gives you access to your funds at regular intervals when each CD matures. For example, if you have $5000 to invest in CD, you can split this into five CDs with different terms. You can put $1000 in each of 1-year CD, 2-year CD, 3-year CD, 4-year CD and 5-year CD respectively. When each of the CDs matures, you can optionally start a new 5-year CD or cash out. With this approach, one of your CDs matures every year, giving you access to your funds. In addition, if interest rate increases, you can take advantage of it.
The major drawback of CDs and share certificate is the fixed term. Any withdrawal of the principal before the maturity date will result in Early Withdrawal Penalty (EWP). Federal law requires banks to charge a minimum penalty of seven days’ worth of simple interest. Institutions may charge higher fees and apply them throughout the CD’s term. It is, therefore, important to check the account agreement for a bank’s specific policies before investing in a CD.
When comparing CDs from different financial institutions, consider the following factors:
· Interest rate: Different institutions have different rates for different CD terms. You may want to shop around and explore rates from different banks and credit unions instead of settling for the first CD you come across. Online tools like bankrate.com and nerdwallet.com may help you find competitive CD offers from multiple financial institutions.
· Term: CD terms are generally in the increment of 3 months between 3 months and 12 months and thereafter in the increment of one year until five years. However, some banks offer odd CD terms like 11 months and 17 months. Longer terms often yield higher rates. For example, the same financial institution may offer higher APY on 1-year CDs than 3-month CDs. However, 3–5-year CDs can have slightly lower rate. This is because banks may expect the Federal Reserve to cut rates in the future. The decision between short-term CD and long-term CD majorly depends on when you may need your money.
· Minimum deposit: Many banks require a minimum deposit for CDs while some do not. Most banks also have tiered APY for CDs where lower deposits have lower APY, and higher deposits have higher APY.
· Early withdrawal penalty (EWP): Each institution is allowed to set its own EWP. While it is more advisable to select the CD with a term that aligns with your financial goal to avoid EWP, it may also be important to select the bank with a more friendly penalty policy because of unforeseen circumstances that may cause you to withdraw from your CD before maturity. Some banks also offer no-penalty CDs, but these generally have lower interest rates than CDs with penalty.
· Financial institution: It is important to consider the stability of the financial institution offering the CD. If an institution offers CDs covered by FDIC, your money is insured up to the $25,000 limit. In the event of a bank failure, you will still get your money.
The bottom line
CDs provide stability and a reliable way to grow your savings over time. In choosing a CD, it is important to research the issuing banks policies, especially the early withdrawal penalty. You want to choose the best CD that aligns with your goals and financial situations. Ultimately, with CDs, you can earn high interest while taking on low risk.